DODD-FRANK, CREDIT RATING AGENCIES AND YOU

Seen as the most significant financial reform bill since the Great Depression, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires massive restructuring of financial regulatory agencies, directs the creation of innumerable new rules, commissions countless studies and reports, and impacts not only U.S. financial institutions, but financial institutions and other commercial companies throughout the world. Aimed at protecting the economy from a repeat of the financial crisis of 2007, the impact of this legislation on the industry is beyond measure. Many believe that large, complex financial institutions will bear the brunt of the impact; however, it appears that community banks will bear more than their fair share. Clearly the expected volume of new banking regulations is staggering; the potential impact of the new Consumer Financial Protection Bureau is daunting; the magnitude of new disclosure and reporting requirements overwhelming; but community bankers should not discount the unexpected consequences of requirements that, at face value, have little to do with traditional community banking. Consider the changes made to the regulation of credit rating agencies set forth in Subtitle C of Title IX of the Act.

Some History on Credit Rating Agencies

Credit rating agencies independently evaluate the credit-worthiness of debt-issuers, including corporations, financial institutions, and governmental entities. Based on this evaluation, the agency assigns a rating which investors use to determine whether or not to invest and the market utilizes to establish the value on the investment given the debt instrument’s interest rate and the credit-worthiness of the issuer. Investors who are risk-averse opt for those obligations with the “best” ratings and are content to earn the lower rate of return associated with these “safer” investments.

While other investment advisors are closely regulated, credit rating agencies have been subject to minimal regulation. Beginning in 1975, the SEC established a process to identify certain credit rating agencies as “nationally recognized statistical ratings organizations” (NRSROs), agencies that issued ratings upon which other SEC-regulated entities could rely to satisfy their own due-diligence requirements. In 2006, the Credit Rating Agency Reform Act (CRARA) was enacted to improve ratings quality for the protection of investors by requiring the SEC to draft and implement rules governing the registration, reporting, and oversight of NRSROs. However, the CRARA specifically prohibited regulation of the credit rating processes and methodologies.

Rationale for this lack of regulation of NRSROs was based on the expectation that market and competitive forces would promote accurate and reliable ratings. Instead, investment banks routinely steered issuers to those agencies most likely to provide favorable ratings, rather than to an agency with a reputation and history of issuing reliable ratings. Not surprisingly, NRSROs altered their rating methodologies to attract future business and increased fees. As the complexity of investments increased, investor due diligence was replaced with investor reliance on NRSRO ratings. The result, seen as one of the primary factors in the current economic crisis, was the downgrade of the triple-A rated subprime mortgage-backed securities to junk status.

Dodd-Frank Changes

Under Dodd-Frank, the SEC will establish a new Office of Credit Ratings with responsibility for exploring the feasibility of standardizing ratings, issuing rules relating to the determination of ratings, and examining and reporting on NRSRO compliance. NRSROs are required to have a board of directors, half of whom are independent, to appoint a compliance officer independent of the rating process or financial performance, to implement and maintain an effective system of internal controls for determining ratings, and to file reports with the SEC attesting to compliance, including changes in compliance controls, code of ethics, and recent employment history of senior officers. NRSROs will also be subject to increased liability for their actions. Additionally, within one year of enactment, federal statutes referencing credit rating agencies and acceptable ratings must be revised to replace these references with defined standards for determining credit-worthiness.

These new requirements will have a clear and significant impact on the NRSROs and other credit rating agencies, as well as on investment banks and large financial conglomerates that participate in securities underwriting and offerings. But how and to what extent will they impact community banks?

The agencies have already published an advanced notice of proposed rulemaking (ANPR) aimed at eliminating the dependence on credit ratings in the risk-based capital standards and Basel. While the standardized approach under the Basel Accord relies extensively on credit ratings to risk weight exposures, operational criteria requiring institutions to independently analyze the credit-worthiness of securitization exposures were subsequently published. These criteria require a bank to have a comprehensive understanding of the risk characteristics of its individual securitization exposure, be able to access performance information on the underlying pools on an on-going basis in a timely manner, and have a thorough understanding of all structural features of a securitization transaction. Although one of the objectives of the agencies’ evaluation of alternative credit-worthiness standards is to “be reasonably simple to implement and not add undue burden on banking organizations” the ANPR acknowledges that the goal may be “achievable only at the expense of greater implementation burden.”

The OCC published an ANPR relating to other regulations that currently rely on credit ratings, including regulations regarding permissible investment securities, securities offerings, and international activities. The regulations surrounding investment securities use credit ratings as a factor for determining the credit quality, liquidity/marketability, and appropriate concentration levels of securities purchased and held by national banks. While the ANPR stresses the fact that institutions should be investing consistent with safe and sound banking practices, the reality is that many institutions were relying primarily on the ratings established by NRSROs in evaluating investments. The ANPR sets forth three alternatives going forward: Credit Quality Based Standard; Investment Quality Based Standard; and Reliance on internal risk ratings. The common theme within these alternatives is the requirement that banks document their credit assessment and analysis of the investment.

These ANPRs clearly indicate that banks will, as a result of Dodd-Frank, devote more resources to activities surrounding capital and investments; resources that are already scarce in community banks. But wait, could there be more …..

The market for mortgage-backed securities is all but extinct; and while securitized credit card receivables continue to be viable, there still remain the underlying risks stemming from the lack of transparency in the credit rating process. How does this risk impact a funding channel utilized by many institutions to regenerate lending capacity? The answer is yet to be seen.

The introduction of regulation to a previously unregulated industry segment will increase the cost of, and most likely extend the timeline for, issuing securities. The amount of information required in underwriting by the agencies will undoubtedly increase, as will the staff required to analyze this information. Rating agencies will increase fees to cover increased administration costs.

The courts are evaluating the issue of reliance on credit rating agencies, and some have ruled in favor of investors. Liability is being assigned to banks that invested client money without performing their own due-diligence based on a breach of fiduciary duty. And, credit rating agency liability is a key component of the Act. Rating agencies will increase fees to cover these costs, too.

Moreover, banks aren’t the only financial intermediaries who have historically relied on credit agency ratings. Investors have enjoyed an increase in the range of available investments; broker-dealers, money funds, pensions, insurance companies, and governments relied on the ratings to reduce the cost of managing their investment portfolios. These market efficiencies favorably impacted the cost and availability of funding for all borrowers. These benefits will likely diminish in the future.

The introduction of higher costs, both from increased administrative expenses and potential liabilities of rating agencies, coupled with increased litigation risks and the regulatory expectation that entities evaluate and demonstrate the appropriateness of their investments, either directly or through the utilization of a third party, will significantly influence the cost and availability of investments and funding. Accordingly, the combined ramifications of Dodd-Frank related to credit ratings agencies will have far reaching effects on a community bank’s business model, encompassing everything from the bank’s own capital, investments, and employee benefit plans, to client activities including lending, trust, insurance, and investments.